A real estate development generally progresses through the following stages before construction can begin:
- Project planning;
- Forming an investment entity;
- Negotiating the development agreement;
- Negotiating the land acquisition and performing due diligence;
- Land use, zoning, and regulatory compliance;
- Retaining the contractor;
- Securing the financing; and
- Closing the acquisition and financing.
A commercial real estate development project typically begins with a real estate developer who formulates and oversees a project from inception through completion. One consideration that a developer typically analyzes is the geographic area in which the development is located. To do so, the developer typically obtains a commercial real estate broker to assist in selecting the best location for the development. Commercial brokers often have access to large databases containing information about potential properties and development locations, including details on the demographics, price, recent sales, and much more.
Once a developer identifies a potential development site, the due diligence phase begins. The preliminary due diligence phase determines the project’s feasibility prior to negotiating a letter of intent or term sheet to purchase the land.
The negotiation aspect of the land acquisition usually coincides with the formation of the investment entity and any joint venture and development agreements, if applicable. If the developer has the financial means, then they may sign a purchase agreement or acquire the land before the investors are committed to development, if the project is to become a joint venture.
What is a joint venture agreement? A joint venture agreement specifies the terms on which investors agree to provide capital for a development project, how that capital will be repaid, and how the various parties will each have a role in the conduct of the entity’s business and management of the project. When a joint venture agreement is drafted for a development project, it often contains financial arrangements between the developer and the investor. Many times, these arrangements involve a development fee and the promote payment structure. What is a development fee? A development fee represents the compensation paid to the developer throughout the construction period. What is the promote? The promote is the disproportionate share of profits paid to the developer following the repayment of capital plus a negotiated return to the investors.
Now, what are purchase and sale agreements? Purchase and sale agreements encompass the many various deal points associated with the acquisition of the land underlying the development, which deal points may include:
- Seller’s representations regarding the property,
- Expiration of the due diligence period, and
- The purchaser’s closing contingencies.
The representations regarding the property include representations that the seller has made about the property and the condition of the buildings on the property (if any) in addition to any known historical information about the property. As for due diligence periods, they are often included as points in purchase and sale agreements, as it is essential that the real estate developer has the opportunity to analyze the property and ensure it is fit for the intended development. Due diligence periods are also used to allow a developer to obtain zoning variances or other land approvals and potentially secure construction financing and engage contractors, architects, and other consultants.
A development agreement is typically entered into between an affiliate of the developer and the property owning-entity. As the developer is often also a partner in the joint venture that owns the land on which the development is taking place, the developer must wear two different hats in the development process. The roles set forth in the development agreement set out the developer’s specific responsibilities as a contractor and building during the construction process and the development agreement also provides the limits on the developer’s authority during this construction period.
One development aspect that often presents many unknowns, and that is time consuming and resource-intensive, is the zoning and land use compliance process. Developers must understand the federal, state, and local laws and regulations regarding zoning, environmental compliance, building and fire codes, and construction labor. This aspect of the due diligence process can take weeks, sometimes years, to complete.
The last stage of the development process before breaking ground is the closing of the land acquisition, which may involve financing transactions. Considering all the fluctuating factors that occur during a real estate development deal, there is no “typical deal,” but rather just what is considered to be standard during a deal.